The U.K. Swallows Austerity So We Don’t Have To

Little brothers exist to be abused by their older siblings. The United Kingdom has willingly played the role of abused sibling for the United States for decades.

When our president wanted to launch a hare-brained invasion of Iraq, no one was more outspoken in his support than Prime Minister Tony Blair. Who is our closest ally in our Vietnam-style occupation of Afghanistan? Yep, it’s the Brits again. And now the new Conservative-Liberal government is taking the lead in trying to use government austerity to restore prosperity.

Those of us who oppose austerity in the United States are delighted. The U.K. is jumping out front to lay off public sector workers, raise taxes, and cut government programs and supports across the board. It is doing this at a time when the economy has nearly 8 percent unemployment and considerably excess capacity in almost every sector of its economy.

This drive to austerity comes at a time when the short-term rate set by the Bank of England is 0.5 percent and the rate on 10-year bonds is just 3.0 percent. The timing is also perfectly wrong in that most of the U.K.’s major trading partners are also suffering from weak economies and therefore unlikely to provide strong export markets. Nor are they likely to tolerate a substantial devaluation of the pound against their currency.

It is really difficult to come up with an economic theory as to how the U.K. austerity drive even could work in principle. The U.K., like the U.S., had enormous overbuilding of residential housing as a result of its housing bubble. Does anyone think that the drive to austerity will lead to a new round of building? (The bubble in the U.K. does not appear to have fully deflated, but this is another story.)

Households in the U.K. are hugely over-extended as they borrowed based on their housing-bubble-generated wealth. Will government austerity cause heavily indebted households to go on a consumption binge? That one does not seem terribly likely, and probably not desirable even if it were to take place. Households will need to accumulate some savings to support themselves in retirement. Another boom based on consumer debt is certainly not a good long-run story for most of the population.

Turning to the business side of the story, demand growth is generally the most important determinant of investment. Demand growth is almost certain to slow precipitously in the context of the sharp cuts being put forward by the government. If firms are not investing now, it is hard to believe that they will invest more when the economy weakens, no matter how excited they might be over the prospect of lower budget deficits.

Finally, it is not clear the government is expecting much of a boost on the trade side, but if they are it would come about through a marked depreciation in the pound, which would raise the price of imports, thereby encouraging the consumption of domestically produced goods. This would also have the effect of raising the inflation rate in the U.K., the comparatively high level of which has been a cause of concern to the Bank of England. If the Bank of England (foolishly) responds to higher inflation by raising rates, it is very hard to see what possible route to growth the deficit hawks would have left to turn to.

There are not many instances of countries adopting the sort of polices that the British government is now embracing, but the examples we have are not encouraging. For example, we have Herbert Hoover’s efforts to balance the budget in 1932 and Franklin Roosevelt’s drive in 1937. Both resulted in a considerable worsening of the economy. Of course, the U.K. had its own experiments with austerity in the middle of the Great Depression, which also did not turn out well for fans of economic growth and full employment.

But, these episodes took place in the distant past and memories in politics are short. However many of us in the United States may feel sorry for the ordinary workers in the U.K. who will be the victims of their bankers and hare-brained elites, it is hard to avoid the feeling that it is better them than us.

Hopefully our little brother will be able to remind every one in the United States of the foolishness of pursuing austerity in the middle of sharp downturn. The Brits will have our gratitude and our sympathy.